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Application of the Business Judgment Rule to Stockholder Derivative Claims

Maryland’s highest court, in Oliveira, et al. v. Sugarman, et al., 152 A.3d 728 (2017), reviewed the lower court’s ruling on whether or not the modified business judgment rule established in Boland v. Boland, 423 Md. 296 (2011), applies to a disinterested and independent board of directors’ decision to deny a shareholder litigation demand.  According to the Court of Appeals, the answer is no.

The common law or tradition business judgment rule provides that courts may apply a presumption of disinterestedness, independence, and reasonable decision making to all business decisions made by a corporate board of directors. The reason for this presumption is so the corporate directors are protected from liability when the majority of directors act prudently and in good faith.  Maryland has codified this common law rule in the Maryland Annotated Code, Corporations and Associations Article 2-405.1.  In order to obtain judicial review of a board’s business decision under the business judgment rule, shareholder must file a derivative claim. 

Derivative claims are claims that exclusively belong to the corporation.  The shareholder is merely operating to enforce a corporate right that the corporation has failed to assert on its own behalf.  In these lawsuits, the corporation is the real party in interest and the shareholder is considered a nominal plaintiff.  The converse to a derivative claim is a direct claim.  Direct claims are claims that are exclusive to the stockholders of a corporation. To establish a direct claim, a shareholder must allege he has suffered an injury that is separate from any harm suffered by the corporation, and the remedy sought will benefit the shareholder as an individual.

Before instituting a derivative lawsuit, procedure requires the shareholder first make a demand that the board of directors take action.  This condition is required because a derivative lawsuit calls into question the managerial control of the board of directors and the demand requirement provides the directors with an opportunity to first exercise their reasonable business judgment.  If a board’s decision is to deny a shareholder demand, to overcome the presumption of reasonableness of the business judgment rule, the shareholder must assert facts that suggest the corporate directors did not act in accordance with the rule.  The burden is on the party challenging the decision to rebut the presumption.

The Boland case established an exception to the application of the business judgment rule to a board’s decision to deny a shareholder’s litigation demand.  Known as the modified business judgment rule, the Court of Appeals held when a board of directors consisting of a majority of interested directors utilizes a special litigation committee (“SLC”) to evaluate a litigation demand, courts will not presume the SLC acted with proper judgment.  The burden of proof under these scenarios is shifted to the corporation to put forth evidence that the SLC acted independently, in good faith and followed reasonable with reasonable procedures.  This modified business judgment rule is considered to be an enhanced standard.

An interested director is defined as a board member that expects to derive personal financial benefit from a transaction or decision as opposed to a benefit which will run to the corporation or all stockholders generally.  If a majority of the board is interested, then the board has the ability to appoint a SLC composed of independent, disinterested directors.  These disinterested directors can be appointed from either inside the corporation or specially appointed from outside the corporation and vested with the authority to render a corporate decision and decide to accept or deny a shareholder’s litigation demand.

In Boland, the board of directors stood to benefit from the decision being challenged by the shareholders, therefore, the court decided to impose the burden on the board of directors to prove the elected SLC was disinterested.   The court’s ruling stems from the fact that when an interested board appoints the SLC, there is a possibility that the SLC could be tainted and that the SLC is merely serving as a puppet for the interested board. A tainted board is not entitled to full presumption of the business judgment rule.

Keeping in mind the principles of Boland, the Maryland Court of Appeals in Oliveira affirmed that the enhanced standard of the modified business judgment rule will not be applied to all instances where a board denies a shareholder litigation demand, but only in the cases where the majority of the board consist of interested directors.  In the cases where the board is disinterested and independent, the traditional business judgment rule will apply since there is an absence of any concern regarding the SLC’s independence and good faith with a truly disinterested board.   

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